CASS Business School MSc International Accounting and Finance

Module Code: SMM471

Exam Title: Corporate Finance and Restructuring

Date: XXX

Time: XXX

Answer TWO questions from Section A, ONE question from Section B, and ALL questions from Section C. Section A carries 36 marks, Section B carries 28 marks and Section C carries 36 marks. Calculators may be used in the examination. Internal Examiner: Dr Giacinta Cestone External Examiner:

Answers
Question 1 Students are expected to discuss the overinvestment problem generated by this WACC fallacy: using the lower asset beta and thus the lower discount rate which is appropriate for the rms core business to value acquisitions in riskier, non-core sectors. Students are expected of course to advise the CFO to use dierent discount rates to value investments with dierent business risks. They should emphasize the fact that the CFOs incorrect use of discount rates will lead to overbidding for acquisition targets that have higher business risk than the acquirer. Finally, students are expected to mention that as a consequence, the acquirers stock price might negatively react upon the bid announcement. The empirical ndings in Kruger, Landier, and Thesmar (The WACC Fallacy: The Real Eects of Using a Unique Discount Rate) have been discussed in class during the Marriot case discussion. Question 2 Students will have to refer to two theories discussed in class that generate through dierent mechanisms - a prediction that investment is positively related to a rms cash. Credit rationing: they are expected to mention the fact that due to information problems rms may not be able to obtain external nancing to start positive NPV projects (as instead would be the case with perfect capital markets). As a consequence, the amount of cash available to rms may be a central determinant of investment. In rms that have large cash reserves, managers may be willing to invest in negative NPV projects, as unveiled by Jensens Free cash ow theory. Question 3 Students will have to explain why in perfect capital markets the choice between payout and retention is irrelevant. They may as well mention what imperfections would instead generate a positive eect of payouts on the stock price they are quite familiar with agency costs of retaining cash and signalling eects of payouts so I expect them to mention these two factors. Question 4 (Similar to exercise 4, Assignment 2) (a) To compute Earnings per Share (EPS), you need rst to compute total earnings and total number of shares post merger. ShowO has a market capitalisation of $400M, hence the acquirer will have to issue 5M new shares, which means that after the merger there will be a total of 15M (=10+5) shares outstanding. Total earnings post merger will be the combined earnings of acquirer and target, that is 60M (=30+30). Hence, total earnings double but the number of shares just goes up by 50%. The merged entitys EPS will then be: 60 = $4 15 . The stock price will be: 800 + 400 = $80 15 . (b) When purchasing a rm with a lower price/earnings ratio than its own, an acquirer will have to issue fewer shares per dollar of additional earnings, thus causing its EPS to increase. This is NOT a good motivation for the merger, as a merger with no synergies adds no
Solution

economic value. If there are no synergies, Understatement Inc. has paid a fair price for ShowO Ltd., and the NPV of the acquisition is zero. Therefore its shareholders are neither better nor worse o. (c) In this case to acquire ShowO, Understatement Inc. has to pay a total of $440 million, so it will have to issue 440/80 = 5.5M new shares, leading to a total NOSH post merger equal to 15.5 million, and an EPS for the merged entity of: 60 = $3.8. 15.5 The EPS is still being boosted by the acquisition, despite a premium being paid for the target. As there are no synergies and a premium is being paid for the target, the NPV of the acquisition from the point of view of Undestatement Inc.s shareholders is negative: Synergy P remium = $40 . Question 5 (Similar to exercise 2, Assignment 2) Asset Substitution 1. The cost of capital for both projects is the risk free rate as investors are risk neutral and thus they do not require a risk premium in this economy. The NPVs of the two projects are: 116 N P VA = 100 = $14.85 1.01 + 62 2 144 1 3 3 100 = $11.55. N P VB = 1.01 2. Since the executive remuneration is linked to the value of the stock, managerial decisions are made so as to maximise the value of equity. The market value of equity under the two investment decisions is: 116 101 = $14.85 EA = 1.01 1 (144 101) 3 EB = = $14.19 < EA . 1.01 Thus, if investors lend the rm $100, managers choose investment A. This in turn implies that a zero coupon bond with face value $101 is fairly priced at $100, as it requires no default premium: 101 D= = $100, 1.01 hence lenders are willing to provide the nancing. 3. The face value of the zero-coupon bond is now $105. The value of equity under the two investment decision is, respectively: 116 105 = $10.47 1.05 1 (144 105) 3 EB = = $12.38 > EA . 1.05 EA =
Solution

Thus, if investors provide the $100 nancing to the rm, managers choose investment B (the riskier project, that entrails a positive probability of default). The zero coupon bond with face value $105 is then not default-free , hence it is not fairly priced at $100: D=
1 + 62 105 3 1.05 2 3

= $72.69

hence potential lenders are not willing to buy the bond. Question 6 (Similar to exercise 12, Assignment 1, but longer) 1. AB Tech has currently $20million in debt outstanding, and equity worth $15 10 = $150 million, hence its current value is $170 million. At current debt level, the present value of tax shields is equal to $0.4 20 = $8 million while expected default costs are zero. The rms unlevered value is then 170 8 = $162 million. In the event of bankruptcy, estimated default costs are equal to 0.20 162 = $32.4 million (of course, these must be multiplied by the probability of default). We then can compute: P V (T S ), the present value of tax shields; P V (DC ), the Expected Default Costs; and the levered rm value (VL ), for each level of debt: D 20 40 50 60 70 80 90 P r(default) P V (T S ) 0% 2% 5% 10% 18% 35% 75% 8 16 20 24 28 32 36 E [DC ] 0 0.648 1.62 3.24 5.83 11.34 24.3 VL 170 177.35 180.38 182.76 184.17 182.66 173.7

Clearly, rm value is maximised at D = $70 million (which implies a VL = $184.17 million). 2. You may answer that this rm faces relatively large indirect costs of default, as its customers are likely to switch to dierent software providers in response to a higher default risk. The rms highly skilled engineers are also likely to leave when default is approaching. 3. In ecient markets the stock price adjusts to its new (post recap) level immediately after the announcement of the leveraged recapitalization. Thus, the price at which the shares are repurchased is the same at which shares trade after the recapitalization. As a consequence, all existing shareholders (whether they sell their shares or not) will be able to capture the tax benets from the recap. The price will be equal to: Pnew = Pold + Vnew Vold $184.17 170 = 15 + = $16.4. Nold 10

Hence, AB Tech will be able to buy about 3 million (= 50/16.4) shares with the proceeds of its debt issue. 4. The initial balance sheet is
Solution

Assets VU = 162 P V (T S ) = 8 170 Also, we know

Liabilities E = 150 D = 20 170

NOLD = 10, and POLD = $15 At the announcement date, the market prices in the eect of the tax shield and the expected costs of default: P V (T S ) E [DC ] = $22.17 million. As a result we have the following balance sheet Assets Liabilities

VU = 162 E = 164.17 P V (T S ) E [DC ] = 22.17 D = 20 184.17 184.17

Note that the new price of equity fully reects the impact of the recap, since PN EW = When debt is issued we have Assets Liabilities 164.17 = $16.4 10

VU = 162 E = 164.17 P V (T S ) E [DC ] = 22.17 D = 70 CASH = 50 234.17 234.17

Note that the price per share has not changed since it is given by PN EW = When shares are repurchased we have EN EW = 114.17, since $50 million are bought back, and thus we obtain Assets Liabilities 234.17 70 = $16.4. 10

VU = 162 E = 114.17 P V (T S ) E [DC ] = 22.17 D = 70 184.17 The number of shares repurchased at the new price is NREP = 50 = 3 million, 16.4 184.17

which implies that NN EW = 7 million. We summarize our results in the following table
Solution

Status Quo P V (T S ) E [DC ] Value of AB Tech Net debt Stock price Shares rep. Shares E 8 170 20 15 10 150

Recap 22.17 184.17 70 16.4 3 7 114.17

Solution